Level 1 Inputs
Level 1 inputs, in the context of financial accounting, are part of a hierarchy of inputs used to determine the fair value of an asset or liability. This hierarchy is used in line with the accounting standard known as the Generally Accepted Accounting Principles (GAAP) or the International Financial Reporting Standards (IFRS), both of which aim to provide consistency and transparency in financial reporting.
Level 1 inputs are defined as unadjusted, quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date. This is the most reliable and accurate type of input for determining fair value.
An active market in this context refers to a market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.
For example, the price of a publicly traded company’s common stock, traded in an active market like the New York Stock Exchange or Nasdaq, would be considered a Level 1 input. Similarly, prices of commodities like oil, gold, etc., that are traded in active futures markets, are also considered Level 1 inputs.
It’s important to note that Level 1 inputs are preferred when available, and firms are encouraged to use lower level inputs (Level 2 and Level 3) only when observable Level 1 inputs are not available. This is due to the reliability and transparency of Level 1 inputs as they reflect actual market transactions and not derived or estimated values.
Example of Level 1 Inputs
Let’s consider an example using common stocks of a publicly traded company:
Suppose you’re an investment fund manager, and your fund owns shares in Apple Inc., which is listed and traded actively on the NASDAQ stock exchange.
At the end of the financial year, when preparing the fund’s financial statements, you need to report the fair value of these Apple shares. Since Apple’s stock is traded in an active market (NASDAQ), you can obtain a quoted price for each share easily, either from the exchange directly, financial news, or online brokerage platforms.
Let’s say on the date of measurement, the closing price of Apple’s stock is $150 per share. If your fund owns 1,000 shares of Apple, the fair value of the investment in Apple shares to be reported on your financial statements is $150 (quoted price) x 1,000 (number of shares), which equals $150,000.
In this case, the quoted market price of $150 per share is a Level 1 input in the fair value measurement. It’s an unadjusted, observable price for an identical asset (Apple’s stock) in an active market (NASDAQ). Because Level 1 inputs are based on actual market transactions, they provide the most reliable and accurate fair value measurements.